The invention relates to a computerized system and a method for implementing a market neutral pairtrade model producing a low risk, high yearly return. Specifically, the invention relates to a computerized system for implementing a pairtrade strategy, wherein the correlation strength between two stocks of a pairtrade is determined such that fortuitous high correlation between these two stocks is substantially excluded. Particularly, the invention relates to a computerized system utilizing a market neutral relative value strategy wherein an optimal symmetric financial hedge ratio between stocks of selected pairtrades is calculated to produce the trading profits substantially overcoming transaction costs.
Nobel Laureate Bill Sharpe says it will xe2x80x9crevolutionize the investment management industry.xe2x80x9d Famed financial planner Harold Evensky calls it xe2x80x9cthe best thing since sliced bread.xe2x80x9d That thing is the market-neutral strategy.
In theory, market-neutral strategies insulate investors from stock-market volatility. Typically, a market-neutral investor uses a computer software to rank thousands of stocks according to how over- or underpriced they are. The investor buys a collection of the underpriced stocks and xe2x80x9cneutralizesxe2x80x9d these purchases by short-selling an equal dollar amount of the overpriced stocks. These strategies make money in a bull market if the owned stocks gain more than the short sales lose.
Each market-neutral manager puts a different spin on the basic strategy. One might screen for stocks using price/earnings ratios while another prefers earnings-growth rates. Some managers try to balance their purchases and short sales within individual sectors and market caps. Others might make small sector bets, overweighing financial stocks, for example, and shorting technology issues. One of these strategies is a correlation/convergence trading strategy (also called statistical arbitrage) designed to make profits without taking significant directional risk. Specifically, this strategy is a trade idea based on the principle that when the price of a stock (or stock portfolio) significantly deviates from its long-term trend, it will sooner or later converge (move back) back to its original trend. For example, a trading strategy that generates a buy signal at every dip of the stock price in a general up trend is a convergence trading strategy.
The convergence strategy primarily focuses on liquid price signals that are significantly strongly correlated. The correlation is defined as the linear regression correlation coefficient of a stock portfolio (or a single stock) and a benchmark over a certain period of time. For example, one can compute the correlation coefficient of IBM stock with respect to the SandP 500 index over the past 6 months. The meaning of correlation coefficient can be simply put this way: if the index moves up, and the correlation coefficient is X, then X percent of the time the stock also moves up.
Basically, the majority of market-neutral strategies work because the market prices of stocks may not have a random, chaotic character, as seems to be the case by following memory-less stochastic or Markov processes. These are the processes in which the future distribution of a variable depends only on the variable""s current value. Stock prices are widely assumed to follow a Markov process. However, as illustrated in FIG. 1 and widely accepted in the investment industry, the typical stock price may be represented as a combination of a random or memory less market signal 10 and an oscillating or swinging rhythmical signal 12 of relatively small amplitude. Further, it has been noted that similar stocks, such as stocks of similar companies in the same industry, are usually well correlated.
Considering an individual stock, it may be noticed that the main component of the price signal is the memory-less signal 10, as shown in FIG. 1. It is because of this overwhelming influence of the random signal, a mean reverting price signal 14 calculated as a sum of the two components of the rice E signal may not be satisfactory reliable. As a result, it is difficult to consistently make profits. In order to enhance a chance of making profits, it was proposed to in trade two or more stocks simultaneously in order to minimize the memory-less 1 component and, at the same time, to rely on the oscillating rhythmic component in the price differential of at least two stocks. In other words, a group of stocks is selected such that the stocks"" random components in the overall trading position are cancelled out, leading to a well defined oscillating and mean reverting price signal. This is illustrated in FIG. 2, showing two related stocks A and B as if they are connected by a spring. The difference between these stocks is an oscillating and mean reverting price signal C, which can be easily traded on: buy lows and sell highs.
In practical terms, as has been explained above, this market neutral portfolio management strategy is based on a classic hedge: a manager looks at stocks in pairs, buying the one he expects to perform best and selling short the one he expects to underperform. The concept has been generalized to accommodate long and short portfolios with different performance expectations.
As ideally as it sounds, the common practice in utilizing the neutral market strategy may not be entirely satisfactory. First of all, while analyzing related stocks, investors typically use the level or daily change correlation coefficient xe2x80x9crxe2x80x9d as a measure of correlation strength between two stocks.
The correlation coefficient is a measure (ranging in value from xe2x88x921 to 1) of the association between a dependent variable and one or more independent variables. If one variable""s values are higher than its average value when another variable""s values are higher than its average value, their correlation will be positive. By contrast, if one variable""s values are lower than its average value when another variable""s values are higher than its average value, their correlation will be negative. Thus, this coefficient is not necessarily a measure of causality, but it does indicate the strength of a relationship. A correlation coefficient of 1 implies that the variables move perfectly in lockstep; a correlation coefficient of 1 implies that the variables move inversely in lockstep; a correlation coefficient of 0 implies that the variables, as calibrated, are uncorrelated. Applying this measure to a pairtrade, it may not exclude fortuitous high correlation. For example, if two totally unrelated stocks or even loosely related stgcks both increase their prices in last few months, a high level of correlation will indicate this trend. Yet, this similarity may rather be explained by the fact that the economy as a whole experiences unprecedented growth, which indiscriminately positively affects a great majority of stocks.
Further, assuming that stock pairs have been xe2x80x9ccorrectlyxe2x80x9d selected, the question arises as to how many shares of an overpriced stock should be shorted versus how many shares of a related underpriced stock should be acquired. For example, if two stocks are weakly correlated, the conventional linear regression slope will be very slightly inclined or near zero. This tells the investor to buy one stock without short selling any shares of the second stock, because shorting the second stock is not going to reduce the total variance of the two-stock portfolio. However, in reality, as mentioned before, if the market suddenly drops significantly, all stocks most likely will tend to drop proportionally. As a consequence, the investor is going to loose a golden opportunity of making profits on an overpriced stock, shares of which he could have sold but did not. In order to avoid this possibility, many financial institutions determine a market neutral hedge. The determination first involves calculating a conventional regression slope xe2x80x9cxxe2x80x9d (FIG. 5) of the time series of the prices of one of the stocks S1 of the selected pair relative to the other stock S2. Further, a conventional regression slope xe2x80x9cyxe2x80x9d (FIG. 5) of the time series of the prices of the stock S2 is determined against the first stock S1. The common practice is to use either x or 1/y as the hedge ratio to achieve the market neutral hedge, which is basically directed at not loosing. However, this hedge ratio may not be an optimal financial hedge which should be ideally directed at making profits. In a market crash, the good financial hedge is the dollar hedge, namely putting the same amount of capital in both the long and the short positions. In contrast, in a pairtrade, there is no distinction between which stock is used as the security to be hedged or the hedging instrument. Ironically, the hedge ratio between the selected stocks is not symmetrical. Traders randomly pick up one of the regression slopes, as described above, and assume that either one of these slopes will lead to the same result. In reality, the results are different and directly depend on which one of the regression slopes is selected.
Further, once a pairtrade is selected, it is necessary to provide sophisticated computerized support helping the traders to optimize cut-loss and profit-taking time points. This is typically achieved by the use of mathematical models that may not be entirely satisfactory.
It is, therefore, desirable to provide a market neutral pairtrade system allowing a trader to choose at least one pair of stocks in a manner that is relatively independent from the influence of market trends on the determination of the correlation strength between these stocks. Also, it is desirable to provide a market neutral pairtrade system operating with an optimal hedge symmetrical hedge ratio to achieve an optimal financial hedge. Further, a market neutral pairtrade system which is provided with a series of tests, including a plurality of templates which are empirically determined to have profitable hedge ratio patterns, to further discard the previously selected pairs that do not show a strong correlation with any of the templates is desirable. Also, a method of operating a market neutral pairtrade system is desirable as well.
The invention achieves these objectives by overcoming the disadvantages known in the known prior. Accordingly, one of the aspects of the invention discloses a market neutral pairtrade system in which a plurality of pairtrades selected by the trader, who uses the level or daily change linear regression coefficient xe2x80x9crxe2x80x9d, is further reduced. This is achieved by computing another de-trended correlation coefficient r_d between stocks of each of tte selected pairs which is determined by substantially equal starting and ending price values within a relatively short time. Only those pairs which have both the high correlation coefficient xe2x80x9crxe2x80x9d and the high de-trended coefficient r13 d will be further analyzed in accordance with the inventive method.
In accordance with another aspect of the invention, the thus selected pairs of correlated stocks are further evaluated by determining a pair of linear regression slopes between the stocks of each pair in order to calculate an optimal symmetrical financial hedge ratio.
Still, in accordance with a further aspect of the invention, the pairs after having been checked with the optimal symmetrical financial hedge undergo a battery of tests to further limit their number. This is achieved by comparing a a general trend of a graph illustrating the correlation between the stocks of each of the selected pairs to a great number of historically determined templates which illustrate most profitable correlation trends. Only after passing the general trend pattern recognition step, the remaining pairs are checked with respect to their amplitudes, number of crosses through the regression line, and the number of standard deviations away from the this line to the last point. All of the remaining pairtrades are presumed to be valid.
Finally, in accordance with another aspect of the invention, the optimal cut-loss and profit taking strategy line indicating when to buy and short-sell is constructed on a basis of the modified LaGrange-Urenbeck process.
It is therefore an object of the invention to provide a market neutral pairtrade system which is operated on a basis of a de-trended correlation measure for reducing the chance of fortuitous correlation between selected pairs of correlated stocks.
Another object of the invention is to provide a market neutral pairtrade system utilizing an optimized symmetric financial hedge ratio to improve the effectiveness of stock hedging in order to obtain an optimal financial hedge.
Still another object of the invention is to provide a market neutral pairtrade system implementing the use of template-matching and further screening technique to further reduce a number of the selected pairs of correlated stocks.
A further object of the invention is to utilize a modified LaGrange-Urenbeck process to find a profit-taking and cut-loss strategy that optimizes the expected profit.
Yet a further object of the invention is to provide a computerized method operating the market neutral pairtrade system in accordance with the invention.